Theories underlying Buy-and-Hold are full of holes

Buy-and-Hold and the idea of building a diversified and static portfolio using domestic and global stocks and bonds according to one’s risk tolerance or investment goals, is built on the foundation of the Efficient Market Hypothesis (EMH), Modern Portfolio Theory (MPT), and the idea that markets follow a “Random Walk” rather than exhibiting any systematic structure.  EMH is the idea that security prices are rationally determined, reflect all available information, and seek equilibrium.  MPT, which resulted in a shared Nobel Prize in 1990 for its founder Harry Markowitz, puts forward the concept of diversification and the thesis that a portfolio can be constructed on the “Efficient Frontier” that optimally balances risk and reward from an “uncorrelated” selection of investments.  The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk per the bell curve or Gaussian distribution and thus the prices of the stock market cannot be predicted.

 Some significant facts that fly against these hypotheses are

1. Warren Buffett and successful market timers who have gotten lucky for a very long time (if these hypotheses are true)

2. Structure that exists in the markets in terms of clear trends and repeatable patterns which manifests themselves as fat tails in price statistics where EMH expects normal Gaussian distributions

3. Large discrepancies between price and fundamental valuation of assets seen frequently over large time periods or during bear markets like 2008, and

4. A correlation in global markets and asset classes seen most strongly since 2008 where most asset classes (stocks, bonds, commodities, real estate, etc.), have generally  dropped and then risen together, some more than others.

Until recently, theorists lacked exposure to a persistent, years long downtrend, so the belief in the Efficient Market Hypothesis (EMH) and the impossibility of a fully diversified crash persisted.  According to this hypothesis, investors cannot consistently beat the markets because markets move in a random fashion and adjust instantly and rationally to the news.  The only path to higher returns is to bear greater risk, however the theory goes on to propose that the risk can be reduced by remaining fully diversified at all times. Modern Portfolio Theory (MPT), builds off these tenets to propose an “efficient frontier” where risk is supposedly minimized and return maximized.   Counterarguments began surfacing in the media after the 2008/2009 market beating.  A Feb 14^th, 2009 headline from Barron’s proclaimed “Modern Portfolio Theory Ages Badly:  The death of Buy and Hold”.  People are questioning the standard 50 year definition of “long-term” and calling for 100-300 years of data which provides a better perspective to understand the decline in 2009 and the subsequent market rally.  Research that contradicts these modern financial theories from the budding field of Behavioral Finance and from top universities has also been emerging.  Prechter and Wagner compile this research in a June 2007 paper published in the Journal of Behavioral Finance titled “The Financial/Economic Dichotomy in Social Behavioral Dynamics – The Socionomic Perspective”, in which they also propose an entirely new model based on the new concept of Socionomics to better explain the workings of financial markets.

The most commonly held out explanation for these times by EMH practitioners is that 2008 was a “black swan” event, i.e. something that happens very rarely, and that things will happily get back on the “random walk” track and efficient markets will return for the long haul … so please go on buy-and-hold’ing through this discontinuity, and in fact buy some more if you will, thank you.  The scientific method would state that the exceptions render the entire theory untrustworthy, especially since there is no way to objectively determine when the theory would work and when it would not.  Benoit Mandelbrot, the late Professor Emeritus of Mathematics at Yale and the author of The Fractal Geometry of Nature and The (Mis)behavior of Markets wrote in a 2006 Financial Times article that “The problem is that measures of uncertainty using the bell curve simply disregard the possibility of sharp jumps or discontinuities and, therefore, have no meaning or consequence. Using them is like focusing on the grass and missing out on the (gigantic) trees. In fact, while the occasional and unpredictable large deviations are rare, they cannot be dismissed as “outliers” because, cumulatively, their impact in the long term is so dramatic … One can safely disregard the odds of running into someone several miles tall, or someone who weighs several million kilogrammes, but similar excessive observations can never be ruled out in other areas of life … Despite the shortcomings of the bell curve, reliance on it is accelerating, and widening the gap between reality and standard tools of measurement. The consensus seems to be that any number is better than no number – even if it is wrong. Finance academia is too entrenched in the paradigm to stop calling it ‘an acceptable approximation’.”

Clearly, there is a massive disconnect between market behavior and economic reality and the rational behavior of investors.  The pillars of modern financial theory may actually have been made of sand rather than stone.  Do you want to build your financial house on these?

Though traditional investment approaches and their underlying theoretical bases cannot be “proved” wrong, the markets and those who understand them, and the buying power of a general investor’s portfolio values tell a different story.  Progress was unleashed on the world after Kepler and Copernicus rang the death knell of the “Flat Earth” hypothesis in the 1500’s.  Our goal at THE ABSOLUTE RETURN is to do the same with your portfolios based on theories that better align with market price and economic history, and which use tactical investment strategies and sophisticated risk management that seeks to preserve your capital, expose your portfolios to less risk for higher potential returns, and provide absolute returns independent of market direction.